When a participant in an ESOP maintained by a privately held company receives employer stock as a benefit payment, the participant has the right to sell the stock to the employer (a "put option"). The ESOP may assume the obligation to purchase the stock. If the participant exercises the put option, the tax law allows the employer (or the ESOP) to elect whether to purchase the stock with a single cash payment or make a down payment and issue a promissory note.
If a promissory note is issued, the law requires the note be payable in equal periodic payments made at least annually over a period no longer than five years, along with a reasonable interest rate. In addition, the law requires that payment of the note be "adequately secured." Some ESOP sponsors pledge the purchased stock back to the participant as collateral. However, the stock pledge and the requirement of "adequate security" may be a problem for several reasons.
First, a question arises as to whether the stock is really "adequate security." Some will argue that pledging the stock of the employer is not "adequate security" because if the employer runs into financial difficulty and cannot make payments on the note, the value of its stock will undoubtedly decrease as well. However, if the employer is the purchaser, the company's assets are often given as collateral for the original ESOP loan, and there may be no other available assets to use as collateral, other than the stock purchased from the participant.
Second, IRS and Department of Labor ("DOL") regulations provide that the only collateral the ESOP may give as security is the stock purchased with the loan (in this case, the promissory note). If pledging the stock as collateral is not "adequate security," the result would be the ESOP cannot use a promissory note to purchase the participant's stock at all, which appears contrary to the statutory authority.
Third, neither the IRS nor the DOL has issued formal guidance regarding whether the pledge of employer stock will be considered "adequate security." Therefore, the plan sponsor and the ESOP is pretty much on its own in attempting to determine what will pass as "adequate security."
In 1994, the IRS did issue a ruling 1 in which it determined that "adequate security" means security which "is capable of being sold, foreclosed upon or otherwise disposed of in case of default." The ruling further holds that a company's "full faith and credit" is not adequate security. Does the ruling mean that if employer stock is pledged back to the participant, and is capable of being sold in the case of default, it would be considered more than the company's "full faith and credit," and therefore is "adequate?" Or, does the ruling mean that something totally apart from the company itself (represented by the stock certificate) is required before the security is deemed "adequate?" The answer is not clear.
The ruling does indicate that regulations defining "adequate security" for other purposes under the tax law 2 are "instructive and should be appropriately adopted" for this purpose as well. This regulation indicates that "[S]tock of a borrowing corporation does not constitute adequate security." However, what if the ESOP purchases the stock rather than the employer? In that event the employer would not be a "borrowing corporation." The IRS Ruling has little precedential value and has not been followed by the IRS or any court. As mentioned earlier, no formal guidance has ever been issued.
There is very little case law regarding "adequate security" when a promissory note is used to purchase the stock distributed to a participant from an ESOP. In a 1995 case 3. former ESOP participants claimed ESOP Trustees had breached their fiduciary duty by purchasing stock from participants with a promissory note secured by a pledge of the stock. The lower court easily found this was not a breach of fiduciary duty, and ruled in favor of the Trustees. On appeal, the Appeals Court sent the case back to the lower court for further proceedings, finding that the facts might have given rise to a breach of fiduciary duty. There are no further reported proceedings for the case.
In a recent decision 4 an ESOP participant sued his former employer claiming violations of ERISA concerning a promissory note. He had received employer stock from an ESOP, exercised his
put option, and sold the stock to the employer. In payment for the stock the employer issued a 10-year promissory note. The note contained an acceleration clause, as required by the plan, which stated: "In the event of the failure to pay any installment of principal and interest. the balance then due hereunder shall become immediately due and payable. " The Court found that the Employer and the ESOP were liable for violations of ERISA because the note should have been payable for no more than 5 years. However, with respect to the issue of whether the acceleration clause constituted "adequate security" for repayment of the note, the Court held that the tax law is "vague" on what is meant by "adequate security," so it would look to the plan itself. Since the plan required the note to contain an acceleration clause, and the note had such a clause, the Court found the note was "sufficiently" secured.
So why is "adequate security" important, anyway? An ESOP is a qualified retirement plan, and must meet all of the tax rules to continue as a qualified plan under the law. If a qualification violation occurs, the result could be devastating. For example, if "adequate security" is not given for a promissory note, the IRS could take the position the plan is not a qualified ESOP. In turn, that could mean a loan made to the ESOP to purchase company stock would be a prohibited transaction, and severe penalties would apply.
OK, so if the rules are not clear, what should an ESOP or the employer do when it wants to purchase stock from a plan participant over a period of years? Perhaps nothing different needs to be done. If the stock is pledged back to the participant as security, and the plan fiduciaries believe such stock is "adequate security," then hopefully no violation is present. In addition, in light of the Craig case, perhaps the ESOP and the promissory note should require an acceleration of the entire debt if there is a default in payments on the note. This would add an argument that the acceleration clause itself constitutes "adequate security."
On the other hand, if the fiduciaries have reason to believe the stock may decrease in value over the next few years, pledging the stock back to the participant may not be "adequate security," and might lead to problems with the ESOP. Finally, perhaps the ESOP should be the purchaser of the stock rather than the employer. A stronger argument can be made that pledging stock back to the participants is "adequate security" if the employer itself is not the purchaser, especially since the stock is the only collateral the ESOP is allowed to give.
An alternative some ESOP companies have considered is to distribute the stock from the ESOP in five annual installments, rather than making a lump sum distribution of stock to the participant and paying the purchase price over five years. The difference is that when stock is distributed in a lump sum, and a promissory note is used to purchase the stock over 5 years, the purchase price for the stock is set at the time the put option is exercised. Any future increase or decrease in stock value will not change the amount paid for the stock.
If the ESOP distributes the stock to the participant in five annual installments, however, each annual distribution is subject to a separate put option at its then current value. If the stock value is trending upward, over the 5-year period the cost to purchase the stock from the participant may be much greater than if the price for all the stock is based on the value at the initial distribution.
ESOP distribution decisions are not easy. Substantial thought must go into the design of ESOP payment provisions. If stock is purchased from the participant using a promissory note, the purchaser must be sure collateral given for the note is "adequate security."
If you would like to learn more about ESOPs, please contact Vern Saper at 616.752.2116 or at firstname.lastname@example.org. or Justin Stemple at 616.752.2375 or at email@example.com .
1 Technical Advice Memorandum 9438002
2 IRS Regulation 1.503(b)-1(b)(l)
3 Roth v. Sawyer – Cleator Lumber Co. ESOP. 61F3d599 (8th Circuit 1995)
4 Craig v. Smith. 597 F.Supp.2d 814 (S.D. Indiana January 2009)